This SIE study exam guide page covers economic policies and factors that influence the security market. In this guide, we understand the Federal Reserve (The Fed), monetary policy, fiscal policy, and different types of interest rates. You’ll also learn about business factors, economic indicators, and international economic factors.
The Federal Reserve Board’s Impact on Business Activity and Market Stability
The Federal Reserve (The Fed) is the most powerful economic institution in the United States, and it controls inflation to keep the country’s economy in good health. It uses various financial techniques to increase employment, decrease inflation, and maintain interest within reasonable parameters.
- Monetary vs. fiscal policy: Monetary policy refers to the actions taken by The Fed to promote the US economy’s health, apart from Congress and the President. A Federal Open Market Committee (FOMC) inside the Federal Reserve reviews the economy eight times a year and makes necessary policy changes. On the other hand, fiscal policy refers to the actions taken by Congress and the President to keep the country’s economy healthy.
- Open market activities and economic impact: The Fed stimulates economic activities by increasing lendable money to banks and decreasing the federal fund rates. Due to lower bank interest rates, consumer spending increases that generate a scope of employment. On the other hand, when the country’s inflation goes high, the Fed shrinks the lendable money supply by banks and increases federal fund rates. Due to this, bank interest rates increase, and consumer spending decreases.
Different rates (e.g., interest rate, discount rate, federal funds rate)
- Interest Rate: The interest rate is the regular interest rate of commercial banks, which charge consumers on loans and credit cards.
- Discount Rate: The discount rate is the interest rate at which commercial banks borrow money from the Federal Reserve.
- Federal Funds Rate: It’s the interest rate that the Federal Reserve sets for banks to charge each other when lending and borrowing excess reserves. The Federal Open Markets Committee (FOMC) sets the federal funds rate as a range between an upper and lower limit, and banks negotiate a specific rate within that range.
Business Economic Factors
The company’s financial statements, like balance sheets, income statements, cash flow statements, and shareholder’s equity statements, play a crucial role in the share price of any security.
- Balance Sheet: The balance sheet is the financial statement that provides details of the company’s assets, liabilities, and shareholder equity. Investors and analysts analyze the balance sheet to determine the company’s health.
- Income Statement: A company’s financial statement records the company’s revenue and expenses in a particular period. The income statement could be released quarterly or annually.
- Cashflow Statement: A financial statement records the company’s cash inflows (money comes in) and cash outflows (money goes out). It shows the company’s cash flow from different sections, such as operating, investing, and financing activities.
- Shareholders Equity Statement: A financial document outlines a company’s ownership interest. It includes common and preferred stock details, additional paid-in capital, retained earnings, and other comprehensive income. This statement provides insights into the company’s net worth attributable to shareholders.
Business Cycle
The Business Cycle refers to an economy’s recurring economic expansion and contraction pattern. It encompasses phases of growth, peak, contraction, and trough. Understanding the business cycle helps investors gauge the economy’s health and make informed investment decisions.
- Expansion: A phase of the business cycle signifies economic growth with rising employment, increased consumer spending, and higher production levels. Investors often seek opportunities during this period to capitalize on favorable market conditions.
- Peak: A phase of the business cycle marks the culmination of economic expansion. During this phase, economic indicators, including employment, production, and consumer spending, reach their highest levels. Investors should exercise caution as the economy may soon transition into a contraction phase.
- Contraction: A phase in the business cycle signifies a decline in economic activity following the peak. During this period, indicators such as employment, production, and consumer spending decrease. Investors typically adopt defensive strategies to mitigate potential losses in a contracting economy.
- Trough: The trough in the business cycle represents the lowest point of economic activity following a contraction. During this phase, indicators like employment and production reach rock bottom before the economy recovers.
- Recovery: A phase in the business cycle denotes the period of economic revival following a trough. During this phase, indicators such as employment and production gradually increase, signaling a resurgence in economic activity.
Economic Indicators
Economic indicators are statistics used to assess the performance of an economy. They include measures like GDP, unemployment, inflation, and consumer confidence index. Understanding these indicators is crucial for investors as they provide insights into the overall health and direction of the economy.
- Leading: Leading economic indicators are metrics that anticipate future economic changes. They include data such as stock market performance, building permits, and consumer confidence levels. Investors use these indicators to forecast economic trends, helping them make informed investment decisions.
- Lagging: Lagging economic indicators are metrics that confirm trends that have already occurred in the economy. Examples include the unemployment rate and labor costs. Investors analyze lagging indicators to validate the economy’s direction, providing insights into past economic performance.
- Coincident: Coincident economic indicators, like employment levels and industrial production, directly reflect the current state of the economy. Investors can use these metrics to assess the real-time health of economic activity, aiding in making informed decisions regarding investments and financial strategies.
- Inflation: It refers to the sustained increase in the general price of goods and services in an economy over a period of time. It erodes the purchasing power of money as prices rise and the value of currency declines. Central banks closely monitor inflation rates to maintain economic stability and control through monetary policy.
Effects on Bond and Equity Markets
- Cyclical: Sectors like industrials often experience higher demand during economic expansions, leading to lower bond prices and higher yields. In equity markets, cyclical stocks tend to perform well as economic growth boosts their earnings prospects, attracting investor interest.
- Defensive: Sectors such as utilities typically maintain stable demand regardless of economic conditions, leading to relatively consistent bond prices and yields. In equity markets, defensive stocks, such as consumer staples, healthcare, and utilities, are favored during economic downturns due to their stable earnings and dividends.
- Growth: Sectors often experience increased demand during economic expansions, leading to higher bond prices and lower yields as investors seek higher returns. In equity markets, growth stocks, typically found in sectors like technology and healthcare, tend to outperform during periods of economic growth due to their strong earnings and revenue growth potential.
Principal Economic Theories
Principal Economic Theories offer diverse perspectives on economic function and policy, including classical, supply-side, and behavioral economics, shaping our understanding of market dynamics and policy formulation.
- Keynesian: Developed by John Maynard Keynes, this theory advocates for government intervention to stimulate demand through increased spending and lower taxes during economic downturns. This theory emphasizes the role of fiscal policy in stabilizing economies and reducing unemployment.
- Monetarist: This theory suggests that monetary policy, rather than fiscal intervention, is the primary tool for achieving economic stability and growth.
International Economic Factors
International factors such as exchange rates, trade policies, and global economic conditions influence a country’s trade balance, competitiveness, and overall economic growth, impacting global businesses, investors, and policymakers.
- U.S. Balance of Payments: The U.S. Balance of Payments records all economic transactions between the United States and the rest of the world. It includes trade in goods, services, and financial assets, impacting the nation’s currency value and overall economic health.
- Gross Domestic Product (GDP): It measures the total value of all goods and services produced within a country’s borders over a specific period. It serves as a key indicator of a nation’s economic performance and overall standard of living.
- Gross National Product (GNP): I measure the total value of all goods and services produced by a country’s residents, domestically and abroad, in a given period. It includes the income earned by citizens and businesses, regardless of their location.
- Exchange Rates: They refer to the value of one currency in terms of another. They fluctuate based on supply and demand dynamics in the foreign exchange market and are influenced by various factors, including interest rates, inflation, geopolitical events, and economic indicators.